Commercial real estate makes an exceptional investment for a number of reasons. The income it yields is usually higher than that of conventional bonds and dividend stocks. Commercial mortgage interest is tax deductible, which may offset taxes on the profits generated by the property. Commercial real estate can also prove to be an effective hedge against inflation and volatile stock markets.
Perhaps best of all is pride of ownership. There’s just something uniquely satisfying about looking at a physical asset and knowing it is yours.
But whether you’re eyeing a piece of multi-family, office space, retail, industrial or hospitality commercial real estate, you know better than to walk into any investment opportunity blind. That asset must align with your financial goals, and not present greater risk than you are willing to assume. Here are five vital things for any investor to look for in a commercial property investment!
1. Good Capitalization Rate
An investment property’s capitalization rate (or cap rate) indicates its rate of return – the net gain (or loss) of that asset as an investment over a specified period of time. Cap rate is determined by dividing the property’s annual operating net income by its market value:
Annual Net Operating Income / Market Value of Asset = Cap Rate
Determining cap rate is easy once you plug the following data into an online cap rate calculator: property value, annual gross income, operating expenses and vacancy rate. These are all figures you should request from the party offering the commercial real estate for sale.
A cap rate between 5 and 10% is considered good. For reference, the average cap rate for retail real estate in the United States was 6.14% in the first quarter of 2022.
2. Long-Term Tenants
Commercial real estate investment would be easy if tenants weren’t a necessary part of the equation. Although short-term tenants can prove useful under certain circumstances, long-term tenants generally provide greater financial stability in the long run.
When you are considering a potential commercial property investment, ascertain whether its current tenants are merely passing through or well-situated with no intention of leaving in the foreseeable future. While you are at it, determine whether the property’s tenants have single net, double net, triple net or gross leases. Each has relative pros and cons, although investors frequently prefer triple net leases because the tenants’ assumption of maintenance, repair, insurance and property tax costs in addition to rent often poses the least risk on their part.
3. Multiple Tenants
Whether a single-tenant commercial property is a wise investment depends heavily on the merits of the tenant. But however strongly a single tenant expresses their intention to remain in the property, whether or not they will continue to stay in business is not totally within their control.
A multiple-tenant property typically represents the more stable investment. Even if one tenant leaves or stops paying their rent, the others will continue to produce the income you need to cover your mortgage and property taxes.
4. The Right Class for Your Investment Goals
A commercial property can receive one of four classifications: A, B, C or D. The best class of commercial property for your investment goals depends on how much money you can invest upfront, how effectively you can address needed repairs, and which types of tenants you are most qualified to market and cater to.
- Class A means a property is top tier. It is recently constructed, still in excellent condition, in a great location, replete with amenities, and has an exemplary modern design. Class A properties naturally have the highest upfront costs, but their reputable tenants and high rents offset them.
- Class B means a property is in the middle of the road. Older Class B properties require more maintenance and likely need some repairs at the time of closing, yet they are still functional and desirable to a wide range of tenants. A Class B property may be upgraded to Class A, but still offers a good cap rate if its condition is preserved instead of improved.
- Class C means a property is lower tier. Its location is as poor as its condition, and it’s not likely to remain functional for very much longer. A Class C property can still represent a promising investment opportunity if operating costs are kept to a strict minimum. Even so, additional expenses must be avoided or mitigated to the greatest degree possible.
- Class D means a property is ancient, decrepit, devoid of on-site or nearby amenities, surrounded by violent crime, and solely desirable to the lowest-income tenants. Few would advise walking into a Class D investment (unless you are purchasing a set for a new Batman movie).
5. Good Location
Although its class reflects a commercial property’s location, you should scrutinize that aspect of the investment separately. When a commercial property has a good location, it is accessible to its tenants’ potential customers and situated near other successful businesses. These qualities make themselves evident through research, although no amount of studying maps and tax data can substitute for actually visiting a potential investment property and judging its location for yourself. You may just discover that the area has potential for growth that other investors overlooked.
If you are considering purchasing or selling commercial property in the greater Detroit Lakes, MN area, contact Action Realty of Detroit Lakes today! We’re standing by to make the local commercial real estate market work in your best interests.